Personal Financial Planning - Risk Management
You get what you need."
The Rolling Stones
Overview
To frame out the process of how we manage portfolio risk, there are three fundamental elements that guide our behavior. First, we believe there is a basic relationship between risk and return. Second, we view diversification as the key to reducing risk. Third, portfolio structure explains performance. Specifically, the asset allocation design used in the construction of our model portfolios directly determines the performance outcome of each model portfolio.
How We Manage Portfolio Risk
We start with the premise that investment management is risk management. We believe the asset allocation strategy used in the construction of an investment portfolio will determine its risk-return relationship. In this regard, we feel there is only one portfolio risk question that needs to be answered: "What mix of index funds provides the highest expected return at each level of risk?"
Our approach to answering this question involves a step process that can be summarized as follows:
Obtain index fund performance data that demonstrate statistically acceptable confidence levels using standard deviation as the primary risk measurement tool. This requires at least twenty years of risk and return characteristics on the indexes.
Select those index funds that best capture the three factors explaining 96% of stock market returns--indexes which offer globally diversified market exposure with a slight tilt toward small cap and value stocks as measured by size and book-to-market ratios. Those include indexes from the United States, International and Emerging Markets.
Using fund correlation measurement tools, assemble those indexes to create "engineered" portfolios in a manner that seeks to achieve relative performance predictability and high expected returns at each level of risk.
Monitor how market movements impact portfolio performance and rebalance underlying index components as appropriate, with the goal of maintaining the integrity of each model portfolio's risk-return profile over time.
Risk-Return Predictability
Because the risk-return relationship in our model portfolios can be measured over long periods of time, a clear and accurate correlation emerges. The consistency of this correlation creates confidence in the design, construction and predictability of expected risk-return relationships. This predictable pattern validates the mathematical discipline built into our investment approach and the benefits of our asset class diversification strategy.
Of course, the usual caveat applies: "PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS." We never want to imply that we are able to predict returns. However, we do feel confident about the predictability of the risk-return relationships achieved in our model portfolios. Thus, we are very comfortable in making the statement: "FUTURE RESULTS SHOULD CONTINUE TO REFLECT, OVER TIME, THE HISTORICAL RISK-RETURN PATTERNS THAT HAVE CHARACTERIZED THE PERFORMANCE OF OUR MODEL PORTFOLIOS."
Four Rules of Portfolio Arithmetic
Let's examine why we are comfortable in making the case about the risk-return predictability of our program. In our view there are four simple investment rules governing portfolio volatility and the expected risk-return relationship:
Any given percentage loss reduces a portfolio's value more in dollar terms than a percentage gain of the same magnitude.
A percentage gain must always be larger than the percentage loss preceding it to get back to a portfolio's original value.
Absolute differences between the percentage gains and losses of portfolios can generate exponential differences in resulting dollar gains and losses for the portfolios.
financial risk management [http://www.cedarwindsblog.com], global risk management [http://www.cedarwindsblog.com/managing-portfolio-risk.html]
The Rolling Stones
Overview
To frame out the process of how we manage portfolio risk, there are three fundamental elements that guide our behavior. First, we believe there is a basic relationship between risk and return. Second, we view diversification as the key to reducing risk. Third, portfolio structure explains performance. Specifically, the asset allocation design used in the construction of our model portfolios directly determines the performance outcome of each model portfolio.
How We Manage Portfolio Risk
We start with the premise that investment management is risk management. We believe the asset allocation strategy used in the construction of an investment portfolio will determine its risk-return relationship. In this regard, we feel there is only one portfolio risk question that needs to be answered: "What mix of index funds provides the highest expected return at each level of risk?"
Our approach to answering this question involves a step process that can be summarized as follows:
Obtain index fund performance data that demonstrate statistically acceptable confidence levels using standard deviation as the primary risk measurement tool. This requires at least twenty years of risk and return characteristics on the indexes.
Select those index funds that best capture the three factors explaining 96% of stock market returns--indexes which offer globally diversified market exposure with a slight tilt toward small cap and value stocks as measured by size and book-to-market ratios. Those include indexes from the United States, International and Emerging Markets.
Using fund correlation measurement tools, assemble those indexes to create "engineered" portfolios in a manner that seeks to achieve relative performance predictability and high expected returns at each level of risk.
Monitor how market movements impact portfolio performance and rebalance underlying index components as appropriate, with the goal of maintaining the integrity of each model portfolio's risk-return profile over time.
Risk-Return Predictability
Because the risk-return relationship in our model portfolios can be measured over long periods of time, a clear and accurate correlation emerges. The consistency of this correlation creates confidence in the design, construction and predictability of expected risk-return relationships. This predictable pattern validates the mathematical discipline built into our investment approach and the benefits of our asset class diversification strategy.
Of course, the usual caveat applies: "PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS." We never want to imply that we are able to predict returns. However, we do feel confident about the predictability of the risk-return relationships achieved in our model portfolios. Thus, we are very comfortable in making the statement: "FUTURE RESULTS SHOULD CONTINUE TO REFLECT, OVER TIME, THE HISTORICAL RISK-RETURN PATTERNS THAT HAVE CHARACTERIZED THE PERFORMANCE OF OUR MODEL PORTFOLIOS."
Four Rules of Portfolio Arithmetic
Let's examine why we are comfortable in making the case about the risk-return predictability of our program. In our view there are four simple investment rules governing portfolio volatility and the expected risk-return relationship:
Any given percentage loss reduces a portfolio's value more in dollar terms than a percentage gain of the same magnitude.
A percentage gain must always be larger than the percentage loss preceding it to get back to a portfolio's original value.
Absolute differences between the percentage gains and losses of portfolios can generate exponential differences in resulting dollar gains and losses for the portfolios.
financial risk management [http://www.cedarwindsblog.com], global risk management [http://www.cedarwindsblog.com/managing-portfolio-risk.html]
